Franchise Securitization Financings

Da v i d J. Ka u f m a n n , Da v i d W. Op p e n h e i m , a n d Jo r d a n E. Ya r e t t

ngaging in the successful • Domino’s Pizza LLC ($1.7 billion) securitization financing of a • Applebee’s Enterprises LLC ($1.794 billion) E franchisor’s royalty stream • Sonic Corporation ($600 million) and/or other sources of revenue can • Quizno’s (confidential) be a complex endeavor. It requires a • IHOP Franchising, LLC ($245 million) particularly sophisticated skill set to What is driving the explosive growth of securitization in the enable the franchisor to take advan- franchise arena? The answer is simple: economics. A franchi- tage of the markedly lower finance sor seeking to borrow funds can typically save upwards of 200 costs (versus conventional bank basis points a year by going the securitization route instead of financing) typically associated with establishing bank credit facilities or engaging in a traditional this type of financing transaction. debt offering. The first year’s savings are not truly savings at all; Although securitizing receiv- David J. Kaufmann they typically will be offset by the significant legal, underwrit- ables is hardly a novel concept— ing, rating agency, insurance, and other credit enhancement fees the technique has been used over required to consummate the securitization transaction. After the the past thirty years to collateralize first year, however, the savings to be enjoyed by a franchisor mortgage, credit card, health care, engaging in a royalty securitization versus conventional bank and automobile lease receivables, financing can prove compelling. among others—no successful secu- Since the first successful franchise securitization involving ritization of a franchisor’s royalty Arby’s in 2000, securitization transactions have evolved and stream had ever been achieved until feature yet additional benefits for franchisors, such as favor- 2000, when Arby’s, Inc. (now Arby’s able amortization terms, limited covenants, and a high level Restaurant Group) raised $290 mil- of marketability. lion through the securitization of the These finance savings reflect the lower interest rates typi- Arby’s royalty stream (a securitiza- cally associated with securitization debt as opposed to either David W. Oppenheim tion subsequently, and successfully, conventional bank financing or the franchisor’s issuance of new closed out through repayment of the debt instruments. Why? The answer is relatively straightfor- securitization notes). ward. In the conventional bank financing or new-debt-offering Since then, securitization has scenario, the amount that can be raised by a franchisor—and proven more and more integral the interest rate payable thereon—is wholly dependent on that to the financing plans of many of franchisor’s balance sheet and income statement and the rating our nation’s largest franchisors. In agency’s view of the franchisor’s overall financial position. In a the past seven years alone, the fol- securitization financing, these elements are simply inapposite. lowing companies have turned to As will be detailed below, the very essence of a securitization— securitization as a means of raising in which a franchisor’s revenue stream is “securitized” (that is, funds for any of a number of stra- turned into securities)—relies upon the structural isolation of tegic reasons (system expansion; that revenue stream in an entity that is legally independent and acquisitions; or retirement of exist- Jordan E. Yarett bankruptcy-remote from the franchisor itself. ing, expensive debt):1 Thus, in the securitization setting, the franchisor’s overall • The Blackstone Group/Hilton Hotels Corporation ($21 creditworthiness is no longer of consequence, leaving only billion) (planned for 2008) the predictability of the royalty and/or other revenue stream • Dunkin’ Brands, Inc. ($1.6 billion) at issue. The rating assigned by one of the nation’s recognized rating agencies to a securitization offering will almost always David J. Kaufmann and David W. Oppenheim are partners in the New be superior to that assigned to a debt or equity offering of the York City firm of Kaufmann, Feiner, Yamin, Gildin & Robbins LLP. Jor- franchisor itself because in the latter scenario, the franchisor’s dan E. Yarrett is a partner in the firm of Paul, Weiss, Rifkind, Wharton overall creditworthiness (including operating and nonoperating & Garrison LLP. This article, originally published as David J. Kauff- liabilities) and bankruptcy exposure must be taken into account. mann, Jordan Yarett, Brian L. Schorr, and Curtis S. Gimson, “Securi- tization: An Overlooked Financial Vehicle for Franchisors,” 20:4 Fran- Finally, and critically, in those many instances in which the fran- chise Law Journal 63 (Spring 2001), includes the authors’ revisions chisor’s revenue stream is deemed so safe and so predictable reflecting current developments. as to qualify, bond insurers will fully insure both principal and

Published in Franchise Law Journal, Volume 27, Number 4, Spring 2008. © 2008 by the American Bar Association. Reproduced with permission. All rights reserved. This information or any portion thereof may not be copied or disseminated in any form or by any means or stored in an electronic database or retrieval system without the express written consent of the American Bar Association. 1 interest on the securitization notes offered to investors, a cir- Finally, but certainly most critically, are the investors that cumstance that can quickly qualify a securitization debt offer- acquire the securitization notes issued by the issuer. Under ideal ing for an AAA rating, driving down even further the interest conditions, these investors are qualified institutional buyers or rate associated with such notes. other qualified purchasers such that registration of the issuer’s In this article, we identify the participants in a securitization offering need not be accomplished under either the Securities transaction, detail how a securitization typically is structured Act of 1933 or any applicable state securities laws.2 and accomplished, and address the key issues of law governing securitization financing activity. Methodology The sine qua non of a securitization financing is the isolation Participants in a Securitization Financing of revenue-generating assets, whose cash flow and liquida- A securitization financing features its own lexicon of participants. tion value are predictable, into a new entity, the SPE, which is In securitization parlance, the franchisor whose revenue stream wholly legally independent of the transferor of those assets and will be securitized is known as the originator, contributor, or bankruptcy-remote from that transferor. transferor. The newly created, structurally isolated, and bank- Franchise agreements (and the right to receive royalties ruptcy-remote entity that will acquire, by means of a “true sale,” thereunder) are the most common type of revenue-generating the franchisor’s revenue-generating assets (its franchise and assets underlying a franchise securitization financing. Note, other revenue-generating agreements) and offer notes secured however, that a franchisor can also elect to engage in a “whole by those assets in a special purpose entity (SPE) (sometimes business securitization,” in which the franchisor enjoys a mul- known as a special purpose vehicle) is known as the issuer. tiplicity of revenue streams that it desires to monetize, such Frequently, an insurance company (frequently referred to as a as construction, equipment, or FF&E (furniture, fixtures, and monoline or wrapper) will participate to irrevocably guarantee equipment) loan receivables from franchisees whose build-out repayment of the principal and/or interest due on the asset- costs are financed by the franchisor; for product-based franchi- backed notes issued by the issuer. Sometimes, a credit enhanc- sors, receivables from product sales to franchisees; for those er—typically a bank, financial assurance company, or insurance franchisors that routinely lease the real estate upon which fran- company—may be brought in to enhance the creditworthiness chised units will be situated, lease/sublease payments; and, in of the securitization offering by means of letters of credit, sure- the guest lodging sector, management fees under management ty bonds, and/or guarantees. agreements, reservation fees, and technology payments. To retain its bankruptcy-remote standing—critical from an Critical to a successful securitization—and the reason why asset isolation perspective and to conform to the legal princi- a more favorable rating and lower interest rate may be forth- ples underlying a securitization, as detailed below—the issuer coming for the same as opposed to a conventional debt offer- typically will have few, if any, employees of its own. Accord- ing or bank financing—is that the subject revenue-generating ingly, vital to a franchise securitization is the servicer, an entity assets, once properly isolated, are now wholly distinct from the that, under contract with the issuer, undertakes to administer balance sheet, overall creditworthiness, and bankruptcy possi- the revenue-generating franchise and other agreements that are bilities of the transferring franchisor. Thus isolated and distinct, the subject of the securitization (and, almost always, administer these revenue-generating assets secure the notes issued by the the entire network as well); ensures that collection of royalties SPE issuer, to the exclusion of claims against them that may be and other receivables due the issuer is properly accomplished; advanced by the transferring franchisor’s other creditors (and, oversees the proper distribution of cash once received; and, at not coincidentally, isolation removes such assets from any pos- all times, performs its activities so that it remains legally dis- sible bankruptcy estate of the transferring franchisor). tinct from the franchisor-originator itself (lest the securitization Indeed, frequently two or more SPEs are utilized in a franchise structure collapse upon a judicial determination that “substan- royalty stream securitization to further achieve the goal of isolat- tive consolidation” of the issuer, the originator, and the servicer ing the issuer’s assets from those of the contributing franchisor. should be accomplished because they improperly blurred dis- Typically, the revenue-generating franchise agreements are sold tinctions among them). or contributed to the issuer SPE (or to another SPE that guar- In a franchise royalty securitization, the servicer is usually antees the issuer’s debt). Another SPE will typically receive, by the originating franchisor itself whose contracts are sold or con- means of sale or contribution, the intellectual property rights of tributed, by true sale, to the issuer (which, in securitization par- the contributing franchisor (including the franchisor’s trademarks, lance, makes the originating franchisor a seller-servicer). service marks, trade name, patents, proprietary and/or confiden- The notes sold by the issuer, as secured by subject franchise tial information, trade dress, copyrights, software, computer pro- agreement revenue streams, may be publicly offered or pri- grams, and all other pertinent know-how). In turn, these assets vately placed; but under either circumstance, the sale almost are licensed back to the issuer SPE so that it (and its affiliates always will involve the services of an investment bank or other and subsidiaries) can offer and sell franchises conveying rights underwriter. Those securities will have to secure a rating from to such intellectual property. By following this protocol, the one of the nation’s widely recognized credit rating agencies, transferring franchisor’s intellectual property, key to the admin- such as Moody’s Investor Services, Inc. (Moody’s) or Standard istration of its network and ability to sell additional franchises, is & Poor’s Ratings Services (a division of the McGraw-Hill Com- potentially shielded, not just from the bankruptcy claims of the panies, Inc.) (Standard & Poor’s). franchisor’s creditors, but from those of the issuer as well.

Published in Franchise Law Journal, Volume 27, Number 4, Spring 2008. © 2008 by the American Bar Association. Reproduced with permission. All rights reserved. This information or any portion thereof may not be copied or disseminated in any form or by any means or stored in an electronic database or retrieval system without the express written consent of the American Bar Association. 2 Other SPEs may be formed to accommodate a franchise secu- franchisor maintains no continuing control over the transferred ritization financing that goes beyond the monetization of royal- assets; the originating franchisor’s financial statements do not ties. For example, if the franchisor typically leases real estate to treat the transferred assets as being owned by the franchisor, its franchisees, then a separate SPE may be formed to hold those but rather sold or contributed; and the transfer agreements leases, receive payments thereunder, and forward the same to reflect a true sale (as opposed to, say, a secured transaction in the issuer. In the guest lodging arena, if reservations system or which the franchisor maintains an interest in the transferred technology payments will be securitized, then another SPE may franchise agreements). be formed to hold and administer the reservation system. To accomplish the type of legal division necessary to with- Yet additional entities may be formed to accomplish a franchise- stand subsequent judicial inquiry, to enjoy bankruptcy-remote related securitization, depending on the circumstances. For exam- status, and to avoid substantive consolidation with the originat- ple, an SPE that is a subsidiary or affiliate (and, in each instance, ing franchisor, the SPE (recall that there may be more than one) a guarantor) of the issuer may be formed to hold franchise agree- should be a newly created entity with no prior business activi- ments entered into prior to the securitization. In addition, because ties; no prior creditors; few, if any, employees; and no actual or the issuer itself typically will not serve as the franchisor under potential claims that a third party could assert against it. The post-securitization franchise SPE’s activities should be agreements, it will form one narrowly confined, its ability or more subsidiaries, which The critical structural feature to issue debt severely restrict- will serve as co-guarantors ed (usually confined solely to for the issuer’s debt, to fulfill of a franchise securitization the ability to issue the sub- this function. (There are two is the isolation of the ject asset-backed notes and, principal reasons not to have perhaps, subsequent subor- the issuer serve as the franchi- revenue-generating assets. dinated debt). Furthermore, sor under post-securitization the franchise agreements and franchise agreements: first, to other assets transferred to the shield the issuer from claims advanced by franchisees and oth- SPE must be free of all liens and other security interests; and ers; and second, the issuer’s balance sheet may render it incapable the ability of the SPE to file for voluntary bankruptcy (or to of securing state franchise registrations absent disruptive escrow, have an involuntary bankruptcy proceeding commenced against surety bond, or fee deferral preconditions because by definition it) must be negated to the greatest extent legally possible. the issuer’s balance sheet will typically reflect either a nominal To maintain its bankruptcy remoteness and avoid a subse- positive or substantial negative net worth.) quent judicial finding that substantive consolidation should As noted earlier, the critical and absolutely indispensable be had, it is critical that the SPE have a corporate governance structural feature of a franchise securitization is the isolation structure separate and distinct from the originating franchisor of the revenue-generating assets (typically the franchisor’s (and, for that matter, from any other entity) such that no alter franchise agreements) at issue. Accordingly, the legal norms ego or other attack to pierce the corporate veil may succeed or governing absolute transfer of assets must be strictly followed. even be credibly advanced. It is vital that, at a minimum, the Therefore, a franchisor undertaking a securitization must trans- following formalities be observed: fer its assets to an SPE in such a way that constitutes, legally • The SPE must conduct its business solely in its own speaking, a true sale. This is typically done in one of two ways: name or through its own agents (including any servicer, either the franchisor’s outright sale of its franchise agreements as discussed below). to the issuer SPE or the franchisor’s capital contribution of the • The SPE’s funds and assets must at all times be separately same to the issuer SPE. In either event, the legal norms gov- maintained. erning a true sale must be strictly observed so that, upon the • The SPE must maintain its own set of complete and cor- bankruptcy of (or other creditor proceeding involving) the orig- rect books and records. If the SPE is a wholly owned sub- inating franchisor, the assets of the issuer SPE (and all other sidiary of the originating franchisor, as is permitted and SPEs) are deemed bankruptcy-remote and are not affected by customary, and the franchisor issues consolidated finan- the franchisor’s bankruptcy and certainly are not “substantively cial statements, then notes to those consolidated state- consolidated” with the originating franchisor. Substantive con- ments should clearly reveal the SPE’s ownership of the solidation is an equitable judicial doctrine pursuant to which a transferred assets. bankruptcy court has the power to consolidate entities not suf- • The SPE must use its own stationery, invoices, checks, ficiently legally distinct, whether under a corporate “alter ego” and other business forms and instruments, distinct from theory or because the entity’s affairs are “hopelessly obscured” those of any other entity (including, most certainly, the (see discussion below). originating franchisor). Legally speaking, a true sale is a transaction in which the • All of the SPE’s liabilities must be paid out of its own risk of loss associated with the subject assets is entirely trans- funds (except for its initial organizational expenses). ferred (in this case from the originating franchisor to the issuer • The SPE may never hold itself out as being liable for, or SPE); the transferring franchisor retains no benefits of owner- assume or guarantee, the debts of any other party. ship with regard to the assets being transferred; the originating • The SPE must fairly and reasonably allocate overhead

Published in Franchise Law Journal, Volume 27, Number 4, Spring 2008. © 2008 by the American Bar Association. Reproduced with permission. All rights reserved. This information or any portion thereof may not be copied or disseminated in any form or by any means or stored in an electronic database or retrieval system without the express written consent of the American Bar Association. 3 expenses that are shared with a related entity, including one or more SPEs involved must precisely delineate just what payments for office space and employees. standards the servicer must adhere to when administering the • The SPE must hold itself out as a separate entity, correct subject franchise network, when selling franchises on behalf any known misunderstandings regarding its separate iden- of the issuer SPE or one of its subsidiaries, and when col- tity, and not identify itself as a division of any other entity. lecting franchisee payments (and paying such payments over • The SPE must maintain adequate capital in light of its to the issuer). These contracts must also delineate events of contemplated business operations. termination. Sometimes, it is prudent to engage an industry • The SPE’s organizational documents must forbid it from consultant, paid for by the issuer, to monitor the performance dissolving, liquidating, merging, consolidating, or selling of the servicer and, upon the occurrence of certain events, ter- substantially all of its assets. minate the servicer and advise and assist the issuer in seeking • The SPE must at all times maintain bank accounts sep- a replacement servicer. arate from those of any other entity and not permit any Frequently, an insurance policy will guarantee the timely other entity independent access to such bank accounts. payment of principal and/or interest in order to obtain the high- • The SPE must observe all corporate or trust (as the case est possible credit rating for the issuer SPE’s notes or other debt may be) formalities. instruments. This is known as credit enhancement. Other forms • All SPE transactions with the originating franchisor and of credit enhancement are letters of credit, surety bonds, guar- other affiliates must be strictly arm’s-length in nature. antees, subordinated loans and the issuance of “senior-subordi- In nonfranchise securitizations, where the subject revenue- nated” debt by the issuer SPE. generating assets are relatively dormant in nature (such as Sometimes the collection of franchise or other agree- mortgages, credit card receivables, equipment leases, health ment receivables will not precisely correlate with the timing care receivables, and other commercial trade receivables), the of payments to noteholders. In such circumstances, one or issuer SPE may engage its own officers and employees to carry more “liquidity facilities” may be required. As opposed to out its responsibilities and affairs. More typically, however, and credit enhancement, however, liquidity providers undertake certainly at all times in the franchise arena, a servicer will be no risk; they are only advancing cash against receivables cer- engaged to administer the subject assets (typically franchise tain to be collected. agreements), collect receivables therefrom, and disperse such Finally, but indispensably, the issuer SPE must obtain the receivables to the issuer for distribution to noteholders (either highest credit ratings possible from Moody’s and/or Standard & directly or indirectly through a third-party paying agent). Poor’s necessary when selling to the public, or to institutional Accordingly, in franchise securitizations (in which fran- investors, the subject notes, debt instruments, preferred stock, chise and related agreements, and the right to receive royalties or other certificates of beneficial interest. Without obtaining and other payments thereunder, are the subject of the securi- optimal ratings from these rating agencies, not only will higher tization and thus transferred to the issuer SPE or an affiliate interest rates result, but it may be difficult for the SPE to find or subsidiary thereof), the SPE will need to engage a servicer investors altogether. Certain categories of institutional investors, to administer those franchise agreements and, indeed, the fran- financial institutions, and others purchasing such asset-backed chise network to which they relate. If separate SPEs from the securities require ratings of a certain caliber to satisfy regula- issuer SPE are established, one to receive and administer preex- tory requirements, investment guidelines, restrictive covenants, isting franchise agreements and another to offer and enter into or internal policies.3 new franchise agreements, then each will enter into a separate It is most important, when effecting a securitization, to bring contract with the servicer and both will guarantee the issuer’s the rating agencies into the picture relatively early on to get debt. The practical result is that the servicer will administer the them comfortable with the transaction and its legal structure subject franchise network and fulfill all of the functions of the and, if need be, to modify the transaction and its structure so originating (now former) franchisor. that the optimal ratings necessary will be forthcoming. But who should be the servicer? Logic dictates, and the law Set forth below is a diagram of a prototypical (simplified for affirms the propriety of, engaging the originating franchisor this purpose) franchise securitization. The transaction involves itself to be the SPE’s servicer. In this setting, the originating a franchisor’s transfer to the issuer SPE of its existing franchise (former) franchisor is now known as a seller-servicer. Recalling agreements and the right to grant future franchises; the franchi- once more the need to keep all SPEs legally and financially dis- sor’s transfer to a separate SPE of its intellectual property (as tinct from all other parties (most certainly the original transfer- broadly defined above); the issuer SPE’s contribution of preex- ring franchisor), the franchisor, when acting as a seller-servicer, isting franchise agreements to a separate SPE and the licensing, must deal with such SPEs on an arm’s-length basis and should on a long-term basis, of its franchising and intellectual property be paid a fee equivalent to that paid to a wholly independent rights (which the issuer receives from the original franchisor) to third-party servicer; and the authority of the originating fran- a subsidiary that, in turn, assigns them to its own subsidiary, the chisor to act as servicer should be revocable by the SPEs on franchisor SPE (which will offer and enter into new franchise terms and conditions that normally would attach to an indepen- agreements); all SPEs appointing the originating transferring dent third-party servicer. franchisor as their servicer; and procurement of an insurance Accordingly, the servicing agreement between the origi- policy guaranteeing repayment of the principal and interest of nating franchisor (which will act as a seller-servicer) and the the issuer SPE’s notes.

Published in Franchise Law Journal, Volume 27, Number 4, Spring 2008. © 2008 by the American Bar Association. Reproduced with permission. All rights reserved. This information or any portion thereof may not be copied or disseminated in any form or by any means or stored in an electronic database or retrieval system without the express written consent of the American Bar Association. 4 Former Franchisor Entity/Servicer IP Servicing Agreement Contribution Contribution of Master Servicing $ of IP Existing Franchise Agreement $ Agmts. and Right to Grant New Franchises Long-Term License of Franchises and

IP Holder Issuer SPE SPE

Contribution of Net Cash Flow Preexisting Agmts. and Guarantee Long-Term License and Associated IP Payment of Rights of Franchising and Net Cash IP Rights Flow and

Note Insurer/ Franchisor SPE Co-Issuer for Master Franchisor Surety Policy Preexisting Agreements SPE (Wholly Owned by Issuer)

Right to Grant Payment of Net New Franchises Cash Flow and and IP License Guarantee Securitization Investors Franchisor SPE for New Agreements

The Post-Securitization Franchisor other hand, if the subject franchise agreements are silent on the Following the securitization financing transaction, and as detailed subject (in which case, under the common law, they generally above, either the issuer itself or, more commonly, another SPE may be freely transferred or assigned) or if such agreements that guarantees the issuer’s obligations will receive all preexist- explicitly permit the franchisor to transfer, sell, or assign the ing franchise agreements of the subject franchisor. With regard same, then no impediment to their transfer exists. to new franchise agreements to be entered following the closing Finally, it must be remembered that all franchise solicitation of the securitization transaction, either the SPE or, again more advertising to be utilized by the new franchisor (whether it be commonly, one of its subsidiaries or affiliates will serve in all the issuer SPE itself or one of its subsidiaries or affiliates) must respects as the franchisor under franchise agreements thereafter be filed in the new franchisor’s name in those franchise registra- entered into (and will likewise guarantee the issuer’s debt). Also tion states that require such filings be effected prior to the use as detailed above, all applicable entities will contract with the of such advertising.6 Recall that pertinent state franchise laws servicer to fulfill their obligations by administering the subject defineadvertising to include not only print and broadcast adver- franchise network and selling new franchises as well (as a reg- tisements but also promotional brochures, certain form letters, istered “franchise broker”). CD-ROMs, DVDs, and nonexempt website solicitation content. Let us focus on the SPE entity that will serve as the network’s franchisor under new or renewed post-securitization franchise Selected Legal Issues agreements. As a brand-new entity, that new franchisor will have Numerous bodies of law will govern and impact the struc- to secure initial franchise registrations in each of the fourteen ture and administration of a franchise securitization financ- states requiring registration.4 In addition, and as is most com- ing, including the law governing commercial transactions mon, if the former franchisor is contracted as the new franchisor’s (most pointedly, the true sale doctrines addressed above), servicer, then that entity will have to register itself as a franchise corporate law (bearing in mind the extreme importance in a broker (in New York, a “franchise sales agent”) in those jurisdic- securitization of isolating, and rendering bankruptcy-remote, tions requiring the registration of independent third-party enti- the revenue-generating assets possessed by the subject SPEs, ties that offer and sell franchises on behalf of a franchisor.5 in part by strictly adhering to corporate law governance and Clearly, if the franchise agreements scheduled to be trans- procedural requirements so as to avoid any attempt to pierce ferred to the issuer SPE (or its subsidiary or affiliate) explicitly the corporate veil of any SPE as part of an effort to substan- bar their sale, assignment, or transfer by the franchisor, then it tively consolidate the SPE’s assets with those of either the will be impossible to utilize the securitization protocol. On the originating franchisor or any other SPE), trademark law (so

Published in Franchise Law Journal, Volume 27, Number 4, Spring 2008. © 2008 by the American Bar Association. Reproduced with permission. All rights reserved. This information or any portion thereof may not be copied or disseminated in any form or by any means or stored in an electronic database or retrieval system without the express written consent of the American Bar Association. 5 that assignments of the franchisor’s intellectual property to are often cited. In the cases12 that depend primarily on the alter one or more SPEs is properly accomplished, filings with the ego analogy, the following factors are often cited as relevant: U.S. Patent and Trademark Office reflecting such assignments (a) parent corporation owns all or a majority of the capital are timely and properly effected, and the resultant licenses stock of the subsidiary; are properly documented), debtor-creditor law, and securities (b) parent and subsidiary have common officers and directors; law (which may govern the issuer SPE’s offer and sale of its (c) parent finances subsidiary; notes, asset-backed debt, and/or securities, assuming that not (d) parent is responsible for incorporation of subsidiary; all will be sold to qualified sophisticated investors exempt (e) subsidiary has grossly inadequate capital; from statutory coverage). (f) parent pays salaries, expenses, or losses of subsidiary; However, the most critical body of law pertinent to a securi- (g) subsidiary has substantially no business except with tization transaction is that of bankruptcy law. Two branches of parent; that body of law are of vital import to a securitization transac- (h) subsidiary essentially has no assets except for those tion: substantive consolidation, as defined above, and the exclu- conveyed by parent; sion of the originating franchisor’s transferred assets from the (i) parent refers to subsidiary as a department or division bankruptcy estate of the franchisor. of parent; (j) directors or officers of subsidiary do not act in the inter- Substantive Consolidation: An Overview est of subsidiary but take directions from parent; In order to satisfy the policies of reorganization, equality of (k) formal legal requirements of the subsidiary as a sepa- distribution, and equitable treatment of creditors, bankruptcy rate and independent corporation are not observed; courts historically have exercised their equitable powers in (l) parent assumes contractual obligations of subsidiary; appropriate circumstances, subject to appropriate exceptions, to (m) parent shifts people on and off subsidiary’s board of treat separate and distinct entities as a single entity for bank- directors; ruptcy purposes, i.e., to substantively consolidate them. Bank- (n) parent misuses corporate form, and parties engage in ruptcy courts have broad discretion in the exercise of their equity non-arm’s-length dealings and transfers; and powers. In the course of applying these equitable powers under (o) parent and its affiliates and subsidiary act from the the rubric of substantive consolidation, courts have looked to same business location. a number of factual indicia of separateness and to the relative At least one court has noted that some of these factors, par- fairness of separate versus consolidated treatment of the assets ticularly the consolidation of financial statement, difficulty of and liabilities of related entities. separating assets, commingling of assets, and profitability to all The reported decisions under the Bankruptcy Act of 1898 creditors, may be more important than others.13 and cases decided shortly after the 1978 enactment of the Bank- A second statement of substantive consolidation elements ruptcy Code rely principally on the presence or absence of cer- appears in In re Vecco Construction Industries:14 tain elements that are identical or similar to factors relevant to (a) the degree of difficulty in segregating and ascertaining piercing the corporate veil or alter ego theories.7 Most subse- individual assets and liabilities, quent cases take such factors into account within the context (b) the presence or absence of consolidated financial state- of a test that more heavily emphasizes a balancing of the ben- ments, efits offered by substantive consolidation against the interests (c) profitability of consolidation at a single physical location, of parties objecting to consolidation. Such decisions examine (d) the commingling of assets and business functions, the impact of consolidation on creditors of the entities at issue (e) the unity of interests and ownership between the vari- and the degree of their reasonable reliance on the separate credit ous corporate entities, of their debtor, instead of cataloging the mere presence of the (f) the existence of parent or intercorporate guarantees or substantive consolidation elements.8 loans, and Although most reported decisions involve attempts to sub- (g) the transfer of assets without formal observance of cor- stantively consolidate debtors under the Bankruptcy Code, porate formalities. courts have, on occasion, consolidated the assets and liabilities The presence or absence of some or all of these elements of nondebtors with those of debtors.9 Some, but not all, of those does not necessarily lead to a determination that substantive courts have held that proponents of the substantive consolidation consolidation is or is not appropriate.15 Indeed, many of the ele- of a nondebtor and a debtor have a heavier burden to satisfy due ments are present in most bankruptcy cases involving affiliated process, among other, concerns.10 In addition, substantive con- companies or a holding company structure but do not necessar- solidation of a nondebtor’s assets with those of a debtor may be ily lead to substantive consolidation. viewed as violating the Bankruptcy Code’s strict requirements In addition to the foregoing factors, poor or nonexistent for the commencement of an involuntary bankruptcy case.11 record keeping of intercompany transactions and of purport- edly separate assets (particularly cash and other liquid assets) Factors Considered and liabilities, whether by design or otherwise, is a common Regardless of which variant of the standard for substantive con- reason for imposing substantive consolidation. Particularly solidation is applied, the elements enumerated in several cases when affiliates’ assets, liabilities, and business affairs are so remain relevant. Two sets of substantive consolidation elements hopelessly entangled that segregation is prohibitively expensive

Published in Franchise Law Journal, Volume 27, Number 4, Spring 2008. © 2008 by the American Bar Association. Reproduced with permission. All rights reserved. This information or any portion thereof may not be copied or disseminated in any form or by any means or stored in an electronic database or retrieval system without the express written consent of the American Bar Association. 6 or impossible, courts are more likely to grant substantive con- parent’s name and logo, the parent selected the subsidiary’s solidation.16 The degree of entanglement is important, however, board members, the subsidiary’s board did not hold for- because the potentially prejudicial effect of substantive consoli- mal meetings, the parent paid the salaries of the subsidiary’s dation is not likely to be justified based on contentions of mere employees, the parent paid the subsidiary’s share of general administrative inconvenience.17 Strict adherence to maintain- office charges, and the parent routinely guaranteed obligations ing corporate or other organizational formalities and separate of the subsidiary.25 books and records, as well as avoidance of commingling of assets, should make it more likely that a court would not order Balancing Benefits and Harm substantive consolidation either for reasons of administrative Under the balancing analysis appearing in a majority of the convenience or on equitable grounds. decisions, proponents of substantive consolidation must not More recent substantive consolidation decisions continue to only demonstrate the existence of substantive consolidation ele- rely at least to some degree on the elements described above.18 ments, such as the failure to observe corporate formalities, but However, the balancing test, discussed below, appears to be at also establish the harm suffered as a result of the existence of least an equally important analysis undertaken in these deci- the elements, as well as the overall benefits to be derived from sions. For example, in In re Creditors Service Corp., the court substantive consolidation. cited Vecco Construction Industries and the factors appearing Balancing the harm and benefit to creditors that would result therein.19 Nevertheless, in determining whether to order the from substantive consolidation, the court in In re Snider Bros., substantive consolidation of a nondebtor individual and several Inc.,26 stated the following principles: the proponent must dem- nondebtor entities with the debtor, the court also noted thus: onstrate a “necessity for consolidation, or a harm to be avoided by use of the equitable remedy of consolidation”; supporting The factors merely provide the framework to assist the Court’s evidence must go beyond a mere showing of commingling or inquiry whether harm will result in the absence of consolidation. unity of interest and must demonstrate the harm caused thereby After a court has decided it has the factual justification to sub- or prejudice without consolidation; elements are only one factor stantively consolidate entities, the ultimate inquiry involves a in the proof of necessity; and even if the proponent can dem- balancing of the equities based on the bankruptcy court’s inher- onstrate the necessity for consolidation, objecting creditors can ent powers pursuant to § 105. [The] Court must be convinced argue the defense that the benefits of consolidation do not coun- that a harm or prejudice to creditors will occur in the absence terbalance the harm to the objectors.27 of substantive consolidation by weighing the equities favoring The balancing test formulated in Snider Bros. has been consolidation against the equities favoring the debtor remaining adopted by many courts, either expressly28 or impliedly.29 separate from the entities and the individual.20 In another often-cited decision, the Second Circuit in In re Augie/Restivo Baking Co., Ltd., reduced the considerations In In re Circle Land & Cattle Corp., the court noted that pertinent to the balancing test to two “critical factors,” namely, although these factors are relevant, the focus has shifted from “whether creditors dealt with the entities as a single econom- “alter ego factors to the effect of the consolidation on general ic unit and did not rely on their separate identity in extending unsecured creditors of the two entities.”21 The court continued credit, . . . or whether the affairs of the debtors are so entangled by noting thus: that consolidation will benefit all creditors.”30 The Second Cir- cuit later affirmed the vitality of this test.31 An applicant must allege equitable grounds for substantive con- A decision from the U.S. District Court for the Southern Dis- solidation such as: that general creditors have dealt with the enti- trict of New York interprets the Second Circuit test as requir- ties as a single economic unit to their detriment; that a necessity ing a court to consider Augie/Restivo’s two critical factors as exists for consolidation to protect creditors; that a harm to the separate bases for substantive consolidation.32 In particular, the creditors could be avoided by the remedy; or that the benefits of court noted that “[t]he Second Circuit’s use of the conjunction consolidation outweigh any resulting harm to general creditors ‘or’ suggests that the two cited factors are alternatively suffi- of the entities.22 cient criteria.”33 Moreover, in addressing the first of the Sec- ond Circuit tests—whether creditors dealt with the entities as a In In re Eagle-Picher Industries, Inc., the court noted that single economic unit and did not rely on their separate identity “the lists presented by the several courts in their decisions, of in extending credit—the court clarified that the test “must be factors which must be present in order to determine the issue applied from the creditors’ perspective.34 The inquiry is whether of substantive consolidation, are of limited use.”23 Instead, the creditors treated the debtors as a single entity, not whether the court adopted the analyses applied by courts within the D.C. managers of the debtors themselves, or consumers, viewed the Circuit (the so-called Auto-Train test) and the Second Circuit, four stores as one enterprise.”35 Consistent with its earlier state- which it said “are not materially different.”24 Nevertheless, the ment, the court in that case found that creditors in fact knew that court in Eagle-Picher, applying the foregoing analyses, did con- they were dealing with separate entities, but then noted thus: sider many of the substantive consolidation factors described in the earlier decisions, noting, for example, that the subsidiary A finding that creditors knew they were dealing with separate was referred to as a division of the parent on checks paid to entities does not necessarily preclude substantive consolidation vendors, the subsidiary’s office and stationery displayed the on the ground that it is impossible or prohibitively expensive to

Published in Franchise Law Journal, Volume 27, Number 4, Spring 2008. © 2008 by the American Bar Association. Reproduced with permission. All rights reserved. This information or any portion thereof may not be copied or disseminated in any form or by any means or stored in an electronic database or retrieval system without the express written consent of the American Bar Association. 7 unravel the debtors’ commingled finances. Consolidation may consolidation, courts must find, with respect to the entities in still benefit all creditors under those circumstances because “the question, that either (a) prepetition, they disregarded their separ- time and expense necessary even to attempt to unscramble [the ateness “so significantly their creditors relied on the breakdown debtors’ separate finances may be] so substantial as to threaten of entity borders and treated them as one legal entity,” or (b) post- the realization of any net assets for all the creditors.”36 petition, “their assets and liabilities are so scrambled that sepa- rating them is prohibitive and hurts all creditors.”46 It remains to In In re Bonham, the Ninth Circuit explicitly adopted the be seen whether other courts will follow the Third Circuit’s lead two-factor test from Augie/Restivo and acknowledged that in circumscribing the use of this equitable doctrine. “[t]he presence of either factor is a sufficient basis to order Therefore, and notwithstanding the widespread acceptance substantive consolidation.”37 of the balancing analysis first articulated in Snider Bros., sev- The Eighth Circuit has held that “[f]actors to consider when eral issues remain unsettled: (a) the continued importance of deciding whether substantive consolidation is appropriate the substantive consolidation elements, (b) the appropriate include 1) the necessity of consolidation due to the interrela- standard for assessing the benefits to creditors of a proposed tionship among the debtors; 2) whether the benefits of consoli- substantive consolidation, and (c) the appropriate standard for dation outweigh the harm to assessing harm to credi- creditors; and 3) prejudice tors objecting to a proposed resulting from not consolidat- Securitization may prove substantive consolidation. ing the debtors.”38 In light of the lack of a The District of Columbia a remarkably advantageous detailed, clearly prescribed Circuit in In Re Auto-Train alternative to conventional standard for determin- required a proponent of sub- ing the appropriateness of stantive consolidation to debt offerings. substantive consolidation show “a substantial identity under existing case law, and between the entities to be con- given the equitable basis solidated. . . .”39 Even after such a showing, however, under for the remedy, any opinion regarding substantive consolida- Auto-Train’s test the proponent must still demonstrate that the tion must, of necessity, be a reasoned opinion based on the benefits of substantive consolidation outweigh any harm to be various elements and the balancing test. As courts have noted, caused thereby.40 substantive consolidation is decided on a case-by-case basis in The “benefits and burdens” test perhaps has been applied light of the unique facts as determined by the bankruptcy court most clearly and consistently to secured creditors whose rights in the case at hand.47 in specific, clearly identifiable collateral would be impaired or destroyed as a result of substantive consolidation. It is a general Franchisor’s Bankruptcy Estate rule that absent a compelling reason, such as fraud, substantive Subject to certain exceptions, § 541(a)(1) of the Bankruptcy consolidation may not reduce a creditor that is secured by specif- Code provides that the commencement of a bankruptcy case ic, identifiable assets to the status of an unsecured creditor.41 As creates an estate, the property of which includes “all legal or a corollary, it is generally agreed that secured creditors’ specific, equitable interests of the debtor in property as of the com- identifiable collateral should not be enhanced, absent unusual mencement of the case.” A bankruptcy trustee of the transferor, circumstances, as a result of substantive consolidation.42 or the transferor as a debtor in possession under the Bankruptcy Finally, in a recent decision, the Third Circuit significantly Code, might assert that the transferor retained an interest in restricted the circumstances under which a court may order the transferred assets, arguing that the transferor did not sell substantive consolidation.43 In reversing the district court’s con- or contribute them to the transferee but rather pledged them solidation of a parent company and a number of its subsidiary to the transferee to secure an obligation. Under this theory, the guarantors, the Third Circuit, favoring the Augie/Restivo test bankruptcy trustee of the transferor’s estate, or the transferor as but unwilling to endorse any specific set of factors, articulated the debtor in possession, might seek (1) a court order requiring a number of principles to guide the court in its analysis.44 These turnover of the transferred assets to the transferor (or the bank- principles include the following: (i) absent compelling circum- ruptcy trustee) as provided by § 542 of the Bankruptcy Code; stances, courts must respect entity separateness; (ii) recognition or (2) an order enforcing § 362(a) of the Bankruptcy Code, the that substantive consolidation nearly always addresses harms automatic stay provision, in order to prevent payment to the caused by debtors disregarding separateness; (iii) mere benefit transferee of the income generated by the transferred assets. of administration is “hardly a harm calling substantive consoli- Whether a bankruptcy court would determine the transferred dation into play”; (iv) substantive consolidation should be used assets to be property of the transferor’s bankruptcy estate turns rarely and as a last resort after alternative remedies have been on whether the transferor’s conveyance of the transferred assets considered and rejected; and (v) substantive consolidation may constitutes a true sale or other absolute transfer, or only the not be used as a “sword.”45 grant of a security interest to secure a purported obligation of Using these principles, the Third Circuit set forth the stan- the transferor to repay money borrowed from the transferee. The dard by which courts in its jurisdiction must weigh requests for Bankruptcy Code does not give guidance, however, on whether substantive consolidation. Specifically, in ordering substantive a debtor has an interest in property or whether it owes a debt.48

Published in Franchise Law Journal, Volume 27, Number 4, Spring 2008. © 2008 by the American Bar Association. Reproduced with permission. All rights reserved. This information or any portion thereof may not be copied or disseminated in any form or by any means or stored in an electronic database or retrieval system without the express written consent of the American Bar Association. 8 Generally, state law dealing with property rights determines Although courts typically give effect to the expressed intent the nature and extent of a debtor’s interest in property.49 “In the of the parties, from time to time courts have either ignored or absence of any controlling federal law, ‘property’ and ‘interests in given only perfunctory attention to such expressed intent where property’ are creatures of state law.”50 Thus, although bankruptcy necessary to prevent an inequitable result or where the stated law defines what property of the debtor constitutes property of intent is manifestly at variance with the actual purpose of the the bankruptcy estate, a bankruptcy court generally will apply transaction.58 In connection with the contribution and assign- state law to determine a debtor’s interest in particular property.51 ment of the transferred assets, however, it would be inequitable A critical factor in resolving the pledge-versus-sale issue is to permit creditors of the transferor to recover the assigned the level and nature of recourse present in a particular transac- assets (or an interest therein) to the detriment of the transferee tion. For example, an owner of receivables or goods is expected where the transferee and the transferee’s creditors had only to bear the risk that the receivables may be uncollectible or that limited recourse to the transferor, i.e., where the transferee will the goods will diminish in value. Conversely, where a trans- provide value to the transferor and the underlying documents feree of receivables has full recourse to the transferor for a defi- require the transferor to (i) note on its financial statements and ciency in the collectibility of the receivables or the value of the in its books, records, and computer files that the transferred goods transferred and bears none of the risks generally associ- assets have been sold, contributed, or transferred to the trans- ated with ownership, the transaction has the characteristics of a feree; and (ii) respond to any inquiries as to the ownership of secured borrowing.52 the transferred assets that the transferred assets have been con- The presence of some recourse, however, does not require tributed or transferred to the transferee. Moreover, where the the conclusion that the transfer is a pledge to secure a loan.53 parties are sophisticated business entities that have deliberately Case law generally permits limited recourse to a seller while structured a transaction to achieve certain legal consequences, still treating the transfer as a true sale. In Major’s Furniture the parties’ expressed intention should be taken into account.59 Mart, Inc. v. Castle Credit Corp., Inc., the court stated that Current Credit Market Crisis [t]he presence of recourse in a sale agreement without more will It would be more than disingenuous for the authors not to note not automatically convert a sale into a security interest. . . . The that, as this article is being written, the U.S. credit markets are question for the court then is whether the Nature [sic] of the experiencing a crisis that may serve as a barrier to all but the recourse, and the true nature of the transaction, are such that the very strongest securitization financing transactions. legal rights and economic consequences of the agreement bear a Ironically, it is securitization activity that triggered the current greater similarity to a financing transaction or to a sale.54 credit market crisis. However, the trigger was not securitization activity involving franchisors. To the contrary, those securitiza- A second factor in determining whether a transfer of assets tions have uniformly proven extraordinarily creditworthy and is a pledge or a true sale relates to whether the transferor has a successful, suffering not even a hiccup along the way. right to redeem the transferred assets. For example, if the trans- No, the type of securitization activity responsible for the action is in fact a secured loan, a transferor would be permitted credit market crisis that began unfolding in the last quarter of to redeem the pledged collateral. In this case, the transferor 2007 and reached crisis mode in January to February of 2008 retains no right to repurchase or redeem the transferred assets related to subprime mortgages. What happened is simple. As after the applicable closing date. noted throughout this article, the very essence of a securi- A number of other factors, in addition to the degree of tization involves isolating dependable, revenue-generating recourse to the transferor and whether the transferor maintains assets in an SPE that is bankruptcy-remote and structured to a residual interest, are relevant in determining whether the be beyond the reach of any other entity’s creditors. The key sale/assignment/contribution will result in a true sale or other word here is revenue-generating. Obviously, if the assets absolute transfer of the transferred assets. Whether the trans- being securitized do not generate revenues, then the securi- feror or the transferee undertakes to collect on the accounts tization will collapse. And that is precisely what happened and notifies the account debtor of the transfer may influence with subprime mortgage securitizations. Pools of subprime the characterization of the transaction. Direct collection by a mortgages were securitized. Many of these mortgages were transferee, with notice to the account debtor, usually indicates all too freely granted by banks and other financial institutions a sale.55 However, it has been observed that, depending on the to less-than-creditworthy individuals during the real estate circumstances, indirect collection from and nonnotification of boom of the past decade and, to make matters worse, featured account debtors do not prevent sale treatment.56 Regardless, a adjustable rates; when interest rates began dramatically esca- lack of actual awareness by any account debtor of the contribu- lating in 2006 and 2007, rates payable under these mortgages tion and/or sale in light of the entire transaction should not be increased as well, leading to widespread defaults and home persuasive evidence that the transfer is a secured loan.57 foreclosures. (In this context, the authors truly believe that the (We note that this factor may not be directly applicable to use of the phrase subprime mortgages is a mere euphemism many of the transferred assets because the account debtor for for “mortgages aggressively marketed to individuals who such assets generally makes centralized payments to either an were not creditworthy and who, given the slightest economic administrative or paying agent without direct knowledge of downturn or rise in adjustable rates, would prove unable to who the ultimate beneficial owner of such assets may be.) fulfill their mortgage payment obligations.”)

Published in Franchise Law Journal, Volume 27, Number 4, Spring 2008. © 2008 by the American Bar Association. Reproduced with permission. All rights reserved. This information or any portion thereof may not be copied or disseminated in any form or by any means or stored in an electronic database or retrieval system without the express written consent of the American Bar Association. 9 Widespread subprime mortgage defaults swiftly escalat- Accordingly, although as of this writing securitization activ- ed into a credit market crisis, as follows. First, a great many ity across the board has dramatically decreased due to the cur- subprime mortgages were sold to investment banks and other rent credit market crisis, the authors believe that, as with past financial institutions, which packaged and securitized them credit market crises, this crisis will abate over the relative short (recall that securitizations involving pooled mortgages were term such that the vibrancy and breadth of securitization activ- among the first to be accomplished in this country). Because ity is not only restored to former levels but, in the franchise mortgage pool securitizations have for nearly forty years arena, surpassed. proven so remarkably safe and dependable, insurance compa- nies—evidently unaware that the subprime mortgages at issue Conclusion carried critically greater risk than the conventional mortgages The structured financing technique known as securitization may traditionally securitized—elected to fully insure principal and/ prove a remarkably advantageous alternative to conventional or interest payments to noteholders of the subprime mortgage debt offerings, bank credit facilities, and public or private place- securitizations. Once widespread subprime mortgage default ments of equity to franchisors seeking to raise cash for strategic ensued, these insurance companies were placed in great peril. reasons. The 200-plus basis point savings in finance costs ver- Indeed, as of February 2008, the scope of these insurance com- sus traditional financing activity have proven sufficiently com- panies’ exposure could not even be quantified. pelling such that at least $4.4 billion of securitization financings In turn, the credit rating agencies either downgraded or have been undertaken in the last seven years alone by some of threatened to downgrade the credit ratings of these insurance our nation’s foremost franchisors, with a single $21 billion fran- companies below the AAA critical for them to qualify for one chisor whole business securitization planned for this year. So it of their main activities, i.e., insuring bonds issued by states, is that the time-tested technique of securitization may join the cities, towns, counties, and quasi-governmental agencies. Nat- initial public offering, the follow-up offering, the debt offering, urally, an inability to engage in such core activity (or even the the private placement of securities, and the bank credit facility threat of such an inability) further weakened their credit ratings as a prime source of financing for large franchisors. and public perception of safety. Without insurance, securitized notes bear greater risk and, accordingly, far greater interest Endnotes rates, making securitization financing activity less attractive 1. Authors David Kaufmann and David Oppenheim served as fran- than it had been (or even impossible to accomplish altogeth- chise counsel either to the securitizing franchisor, the investment bank/ er, given investor wariness of any securitization financing not underwriter, or the securitization note insurer in all of the securitiza- accompanied by fully insured securitization notes). tion transactions referenced in this article except Quizno’s; and author However, the authors believe that, as happened following Jordan Yarett served in similar capacities in all of the securitization significant credit market crises in decades past, the current cri- transactions referenced except Blackstone/Hilton. sis, too, will pass. U.S. financial markets cannot survive, let 2. 15 U.S.C. § 77 et seq. alone thrive, without insurance companies insuring a plethora 3. See Richard Cantor & Frank Packer, The Credit Rating Industry, of debt offerings (including securitization notes). Without such Fe d . Re s . Ba n k o f N.Y. Q. Re v . 1, 10-12 (Summer–Fall 1994). insured asset-backed securities, the ability of federal, state, 4. California Franchise Investment Law, Ca l . Co r p . Co d e § 31000 city, town, county, and other government entities to issue bonds et seq. (1970); Hawaii Franchise Investment Law, Ha w . Re v . St a t . to pay for schools, roads, airports, bridges, and other public § 482-E1 et seq. (1974); Illinois Franchise Disclosure Act, 815 Il l . projects will be severely constrained. Further, critical securi- Co m p . St a t . 705/1 et seq. (1988); In d . Co d e 23-2-2.5(1) et seq. (1983); tization activity involving creditworthy mortgages, health care Maryland Franchise Registration and Disclosure Law, Md. Co d e An n ., receivables, credit card receivables, automobile lease receiv- Bu s . Re g . § 14-201 et seq. (1992); Michigan Franchise Investment Law, ables, and so forth—activity vital to this nation’s economy— Mich . Co m p . La w s § 445.1501 et seq. (1974); Mi n n . St a t . § 80C.01 et will likewise prove difficult to accomplish. seq. (1973); N.Y. Ge n . Bu s . La w art. 33, § 680 et seq. (1980); North It is thus not surprising that even as this article is being Dakota Franchise Investment Law, N.D. Ce n t . Co d e An n . § 51-19-01 written, various efforts are under way to put the credit market et seq. (1975); Rhode Island Franchise and Distributorship Investment crisis behind us. The subject insurance companies are engag- Regulations Act, R.I. Ge n . La w s § 19-28.1-1 et seq. (1993); South ing in secondary offerings of securities to raise capital in an Dakota Franchises for Brand-Name Goods and Services Law, S.D. effort to maintain their crucial AAA financial strength ratings. Co d ifi e d La w s § 37-5A-1 et seq. (1974); Virginia Retail Franchising The Insurance Commissioner of New York revealed that he is Act, Va. Co d e An n . § 13.1-557 et seq. (1972); Washington Franchise working with Wall Street’s major investment banks in an effort Protection Act, Wa s h . Re v . Co d e § 19.100.010 et seq. (1972); Wiscon- to have them make similar investments in those insurance com- sin Franchise Investment Law, Wi s . St a t . § 553.01 et seq. (1971). panies whose participation in securitization financings is so 5. California has in the past sometimes required that the servicer critical. And the federal government, in addition to its February register as a subfranchisor (California’s Franchise Investment Law 2008 $150 billion economic stimulus package, has established does not require the registration of franchise sales agents or brokers). various means through which holders of subprime mortgages 6. California Franchise Investment Law, Ca l . Co r p . Co d e § 31156; with adjustable rates can refinance at a low fixed-interest rate In d . Co d e 23-2-2.4 (4); Maryland Franchise Registration and Disclo- made possible by the Federal Reserve’s dramatic January 2008 sure Law, Md. Co d e An n ., Bu s . Re g . § 14-225; Mi n n . St a t . § 80C.09; core interest rate cuts. N.Y. Co m p . Co d e R. & Re g s . tit. 13, § 200.09; North Dakota Franchise

Published in Franchise Law Journal, Volume 27, Number 4, Spring 2008. © 2008 by the American Bar Association. Reproduced with permission. All rights reserved. This information or any portion thereof may not be copied or disseminated in any form or by any means or stored in an electronic database or retrieval system without the express written consent of the American Bar Association. 10 Investment Law, N.D. Ce n t . Co d e An n . § 51-19-10; Rhode Island corporate veil, nondebtor affiliates cannot argue that there is no per- Franchise and Distributorship Investment Regulations Act, R.I. Ge n . sonal jurisdiction as to them); see also In re Amco Ins., 444 F.3d 690, La w s § 19-28.1-12; South Dakota Franchises for Brand-Name Goods 695 n.3 (5th Cir. 2005), cert. denied, 127 S. Ct. 389 (2006) (noting and Services Law, S.D. Co d ifi e d La w s § 37-5A-44; Washington Fran- concerns regarding consolidating a nondebtor with a debtor and that chise Protection Act, Wa s h . Re v . Co d e § 19.100.100. courts should be more cautious when granting such requests). 7. See, e.g., In re Gulfco Inv. Corp., 593 F.2d 921, 928 (10th Cir. 11. See In re Colfor, Inc., 1997 WL 605100, at *3–4 (if committee 1979); In re Vecco Constr. Indus., 4 B.R. 407, 409–10 (Bankr. E.D. seeks to bring nondebtor into bankruptcy, it should file involuntary peti- Va. 1980). tion against the nondebtor under 11 U.S.C. § 303); In re Circle Land & 8. See, e.g., In re Bonham, 229 F.3d 750, 766 (9th Cir. 2000); In re Cattle Corp., 213 B.R. 870, 877 (Bankr. D. Kan. 1997) (agreeing with Reider, 31 F.3d 1102, 1106–07 (11th Cir. 1994); In re Giller, 962 F.2d decisions that “reason that consolidation of a non-debtor is contrary to 796, 799 (8th Cir. 1992); In re Augie/Restivo Baking Co., Ltd., 860 the Code limitations for involuntary bankruptcy petitions”); In re Ira F.2d 515, 518 (2d Cir. 1988); see also In re Verestar, Inc., 343 B.R. S. Davis, Inc., No. 92-142595, 1993 WL 384501, at *7 (E.D. Pa. 1993) 444, 462–63 (Bankr. S.D.N.Y. 2006); In re Bennett Funding Group, (citing 11 U.S.C. § 303). But see In re United Stairs Corp., 176 B.R. Inc., 253 B.R. 316, 322 n.9 (Bankr. N.D.N.Y. 2000); In re Ltd. Gaming 359, 369–70 (Bankr. D.N.J. 1995) (where the nondebtor entities are of Am., Inc., 228 B.R. 275, 287 (Bankr. N.D. Okla. 1998); In re Leslie alter egos of the debtor, requirements for filing an involuntary case do Fay Cos., 207 B.R. 764, 779–80 (Bankr. S.D.N.Y. 1997); In re Colfar, not apply to prevent substantive consolidation). See also In re Bonham, Inc., Nos. 96 60306, 96 60307, 1997 WL 605100, at *2–3 (Bankr. N.D. 226 B.R. 56, 75 (Bankr. D. Alaska 1998), aff’d, 229 F.3d 750 (9th Cir. Ohio Sept. 4, 1997); In re 599 Consumer Elecs., Inc., 195 B.R. 244, 2000) (noting that in “a slight majority of the cases which have decided 247–51 (S.D.N.Y. 1996); In re Eagle-Picher Indus., Inc., 192 B.R. 903, the issue, courts have held that the estate of a non-debtor can be con- 905–06 (Bankr. S.D. Ohio 1996); In re Apex Oil Co., 118 B.R. 683, solidated into that of a debtor under the appropriate circumstances”). 692–93 (Bankr. E.D. Mo. 1990); In re Crown Mach. & Welding, Inc., 12. See In re Tureaud, 45 B.R. at 662, aff’d, 59 B.R. 973 (N.D. Okla. 100 B.R. 25, 26–28 (Bankr. D. Mont. 1989); In re Steury, 94 B.R. 553, 1986) (citing Fish v. East, 114 F.2d 177, 191 (10th Cir. 1940)); In re 554–55 (Bankr. N.D. Ind. 1988); In re DRW Prop. Co., 82, 54 B.R. Gulfco, 593 F.2d at 921; see also In re Giller, 962 F.2d at 798–99; In re 489, 495 (Bankr. N.D. Tex. 1985); In re Snider Bros., Inc., 18 B.R. Affiliated Foods, Inc., 249 B.R. 770, 776–84 (Bankr. W.D. Mo. 2000); 230, 234, 236–38 (Bankr. D. Mass. 1982); In re Lewellyn, 26 B.R. 246, In re Apex Oil, 118 B.R. at 692–93 (relying, in part, on such factors but 251–52 (Bankr. S.D. Iowa 1982). But cf. G.M. Mather v. G.K. Pipe also considering fairness of substantive consolidation to creditors). Corp. (In re Moran Pipe & Supply Co., Inc.), 130 B.R. 588, 591–93 13. See Lease-A-Fleet, 141 B.R. at 877 (noting that in that particu- (Bankr. E.D. Okla. 1991) (relying entirely on alter ego factors); In re lar case, “the more important factors” had not been alleged or asserted Gainesville P-H Props., Inc., 106 B.R. 304, 304–06 (Bankr. M.D. Fla. “with any degree of particularity”). 1989) (relying primarily on alter ego factors). 14. 4 B.R. 407, 410 (Bankr. E.D. Va. 1980). 9. See, e.g., In re Bonham 229 F.3d at 760, 765 (Ninth Circuit 15. See In re Donut Queen, Ltd., 41 B.R. 706, 709–10 (Bankr. upholds bankruptcy court’s substantive consolidation of debtor and E.D.N.Y. 1984) (criteria should not be mechanically applied in deter- nondebtors involved in Ponzi scheme to assure that overcompensated mining consolidation; rather, factors should be evaluated within the initial investors share in losses suffered by subsequent investors); In re larger context of balancing the prejudice resulting from the proposed Creditors Serv. Corp., 195 B.R. 680, 690–91 (Bankr. S.D. Ohio 1996) order of consolidation with the prejudice alleged by creditor from the (substantive consolidation warranted where there was a complex web debtor’s separateness); see also In re Drexel Burnham Lambert Group of transactions among parties, evidence of fraudulent concealment of Inc., 138 B.R. 723, 764–65 (Bankr. S.D.N.Y. 1992) (the consolidation debtor’s postpetition operations, entanglement of financial affairs of factors must be “evaluated within the larger context of balancing the debtor and nondebtors, benefit of substantive consolidation far out- prejudice resulting from the proposed consolidation against the effect weighed any detriment, and no creditors objected). of preserving separate debtor entities”). 10. Compare In re Lease-A-Fleet, Inc., 141 B.R. 869, 874–78 16. See In re Creditors Serv. Corp., 195 B.R. 680, 690–91 (Bankr. S.D. (Bankr. E.D. Pa. 1992) (consolidation of debtor and nondebtor should Ohio 1996); In re New Ctr. Hosp., 187 B.R. 560, 569 (E.D. Mich. 1995). be reserved for unusual circumstances, such as the existence of sham 17. See In re Bonham, 226 B.R. 56, 76 (Bankr. D. Alaska), a f f ’d , operations or corporate shells, where nondebtor is alter ego and instru- 229 F.3d 750 (9th Cir. 2000) (“Substantive consolidation should not mentality of debtor or where there is an impossibility of disentangling be used as a mere device of convenience, e.g., to overcome accounting assets and liabilities of debtor and nondebtor), and In re Alpha & difficulties, where it would unfairly impair the vested rights of some Omega Realty, Inc., 36 B.R. 416, 417 (Bankr. D. Idaho 1984) (fact that of the creditors.”). Compare In re Jeter, 171 B.R. 1015, 1020 (Bankr. general partnership that was related to a debtor corporation was not W.D. Mo. 1994) (evidence of financial commingling sufficient to sup- itself a debtor under the Code precluded substantive consolidation), port substantive consolidation), a f f ’d , 178 B.R. 787 (W.D. Mo. 1995), with In re New Ctr. Hosp., 187 B.R. 560, 567–69 (E.D. Mich. 1995) a f f ’d , 73 F.3d 205 (8th Cir. 1996), and In re Standard Brands Paint (bankruptcy court can substantively consolidate assets of debtor with Co., 154 B.R. 563, 572 (Bankr. C.D. Cal. 1993) (although debtors those of nondebtors under 11 U.S.C. § 105(a)), and In re Tureaud, 45 were not entangled in a “records sense,” court ordered substantive B.R. 658, 662 (Bankr. N.D. Okla. 1985) (trustee met required standard consolidation, finding that “in a functional sense the affairs of all five for disregarding separate corporate entities to allow substantive con- debtors are so entangled that consolidation will benefit all creditors, solidation of nondebtor affiliates with the debtor), aff’d, 59 B.R. 973, because the effect/validity of the intercompany debts and guarantees 977 (N.D. Okla. 1986), and In re 1438 Meridian Place, N.W., Inc., 15 will not have to be sorted out”), and In re Vecco Constr. Indus., 4 B.R. B.R. 89, 95 (Bankr. D.D.C. 1981) (where there are grounds to pierce at 410–11 (substantive consolidation granted without opposition when

Published in Franchise Law Journal, Volume 27, Number 4, Spring 2008. © 2008 by the American Bar Association. Reproduced with permission. All rights reserved. This information or any portion thereof may not be copied or disseminated in any form or by any means or stored in an electronic database or retrieval system without the express written consent of the American Bar Association. 11 debtors had single operating account and consolidated financials; had In re N.S. Garrott & Sons, 48 B.R. 13, 18 (Bankr. E.D. Ark. 1984) made no attempt to segregate receivables, disbursements, or income; (adopting Snider Bros. principles as important factors); In re Luth, had inaccurately allocated affiliate expenses through intercompany 28 B.R. 564, 567 (Bankr. D. Idaho 1983) (citing Snider Bros. test as accounts; and had filed bankruptcy schedules on a consolidated basis), another “element”). and In re Baker & Getty Fin. Servs., Inc., 78 B.R. 139, 142 (Bankr. 30. 860 F.2d 515, 518 (2d Cir. 1988) (citations omitted). N.D. Ohio 1987) (substantive consolidation ordered when corporate 31. See FDIC v. Colonial Realty Co., 966 F.2d 57, 61 (2d Cir. 1992) funds were extensively commingled and used for principal’s personal (in dicta); see also In re Verestar, Inc., 343 B.R. 444, 462 (Bankr. purposes, segregation of assets could not accurately be accomplished, S.D.N.Y. 2006) (noting that in Augie/Restivo, “the Second Circuit funds were transferred without adherence to corporate formalities, reformulated the factors as two”). and corporate entities were alter egos of principal that exercised per- 32. In re 599 Consumer Elecs., Inc., 195 B.R. 244 (S.D.N.Y. 1996); vasive control over debtors’ financial affairs), and In re Tureaud, 45 see also In re Verestar, Inc., 343 B.R. at 462–63. B.R. at 661 (extensive commingling of personal and corporate assets, 33. In re 599 Consumer Elecs., Inc., 195 B.R. at 248; see also In numerous undocumented intercorporate transfers, lack of distinction re Bonham, 229 F.3d 750, 766 (9th Cir. 2000) (the presence of either between intercompany transactions despite separateness of books and Augie/Restivo factor is sufficient to order substantive consolidation). records, indiscriminate use of different corporate names within single 34. In re 599 Consumer Elecs., Inc., 195 B.R. at 248. transaction, and impossibility of accurately tracing all transfers), with 35. Id. at 249. In re Reider, 31 F.3d 1102, 1109–11 (11th Cir. 1994) (erroneous listing 36. Id. at 250 (quoting In re Augie/Restivo, 860 F.2d 515, 519 (2nd of both entities’ land on debtor’s schedules and some evidence of com- Cir. 1988)). mingling of funds are not sufficient for substantive consolidation where 37. 229 F.3d at 766. proper allocation of funds can be readily made and harm to creditors 38. In re Giller, 962 F.2d 796, 799 (8th Cir. 1992); see also In re resulting from substantive consolidation outweighs benefits),and In re Affiliated Foods, Inc., 249 B.R. 770, 784 (Bankr. W.D. Mo. 2000) Ford, 54 B.R. 145, 147–50 n.6 (Bankr. W.D. Mo. 1984) (evidence of (Giller analysis here supports consolidation of three bankruptcy estates commingled corporate and personal funds in corporate bank account, that have been so intertwined in their business and corporate relations common use of funds, and common responsibility for loans held insuf- as to be practically indistinguishable; consolidation will benefit all ficient to blur the distinction between the entities and inadequate for creditors while nonconsolidation will benefit only one creditor); In re substantive consolidation). Apex Oil Co., 118 B.R. 683, 692–93 (Bankr. E.D. Mo. 1990) (substan- 18. See, e.g., In re Creditors Serv. Corp., 195 B.R. at 689; In re tive consolidation supported by analysis of interrelationship among the Eagle-Picher Indus., Inc., 192 B.R. 903, 906–07 (Bankr. S.D. Ohio debtors; basic fairness to creditors; and prejudice to creditors and the 1996); In re New Ctr. Hosp., 187 B.R. 560, 569 (E.D. Mich. 1995); In debtors resulting from not consolidating the debtors, including the sub- re Gucci, 174 B.R. 401, 413 (Bankr. S.D.N.Y. 1994). stantial cost of untangling the debtors’ affairs). 19. In re Vecco Const. Indus., 4 B.R. at 407. 39. In re Auto-Train Corp., Inc., 810 F.2d 270, 276 (D.C. Cir. 1987); 20. In re Creditors Serv. Corp., 195 B.R. at 690 (citations omitted). see also In re Standard Brands Paint Co., 154 B.R. 563, 572–73 (Bankr. 21. In re Circle Land & Cattle Corp., 213 B.R. 870, 876 (Bankr. D. C.D. Cal. 1993) (discussing the Auto-Train test, the court found that a Kan. 1997). parent and four debtor subsidiaries did not meet the substantial identity 22. Id. test in the old alter ego / piercing the corporate veil sense, but rather 23. 192 B.R. at 905. in “functional terms” because they functioned as a single consolidated 24. Id. entity and there were multiple interdebtor guarantees and interdebtor 25. Id. at 906–07. debts). 26. In re Snider Bros., Inc., 18 B.R. 230, 238 (Bankr. D. Mass. 1982). 40. In re Standard Brands Paint, 154 B.R.. at 572; see also In re 27. Id. Reider, 31 F.3d 1102, 1107–08 (11th Cir. 1994) (reaffirming the adop- 28. See Drabkin v. Midland-Ross Corp. (In re Auto-Train Corp., tion of the Auto-Train test in the Eleventh Circuit and emphasizing the Inc.), 810 F.2d 270, 276 (D.C. Cir. 1987); Holywell Corp. v. Bank of impact of substantive consolidation on creditors of the entities at issue, N.Y., 59 B.R. 340, 347 (S.D. Fla. 1986), appeal dismissed, 820 F.2d and the degree of their reasonable reliance on the separate credit of 376 (11th Cir. 1987), reh’g denied, 826 F.2d 1010 (11th Cir. 1987), their debtor, instead of cataloging the mere presence of the substantive vacated, 838 F.2d 1547 (11th Cir. 1988), cert. denied, 488 U.S. 823 consolidation elements). (1988); In re Creditors Serv. Corp., 195 B.R. 680, 690 (Bankr. S.D. 41. In re Gulfco Inv. Corp., 593 F.2d 921, 930 (10th Cir. 1979); In Ohio 1996); In re Eagle-Picher, 192 B.R. at 905; In re Steury, 94 B.R. re Dynaco Corp., 184 B.R. 637, 638, n.1 (Bankr. D.N.H. 1995). 553, 554 (Bankr. N.D. Ind. 1988); In re Baker & Getty Fin. Servs., Inc., 42. In re Cooper, 147 B.R. 678, 682 (Bankr. D.N.J. 1992) (citations 78 B.R. 139, 142 (Bankr. N.D. Ohio 1987); In re DRW Prop. Co., 82, omitted). 54 B.R. 489, 495 (Bankr. N.D. Tex. 1985); In re Donut Queen, Ltd., 41 43. In re Owens Corning, 419 F.3d 195 (3d Cir. 2005), amended B.R. 706, 709 (Bankr. E.D.N.Y. 1984); In re Lewellyn, 26 B.R. 246, by 2005 U.S. App. LEXIS 18043 (Aug. 23, 2005), rev’g 316 B.R. 168 251 (Bankr. S.D. Iowa 1982); In re F.A. Potts & Co., 23 B.R. 569, 572 (Bankr. D. Del. 2004), cert. denied, 126 S. Ct. 1910 (2006). (Bankr. E.D. Pa. 1982). 44. In re Owens Corning, 419 F.3d at 211. 29. See Eastgroup Props. v. S. Motel Ass’n, Ltd., 935 F.2d 245, 45. Id. 249 (11th Cir. 1991); In re Silver Falls Petroleum Corp., 55 B.R. 495, 46. Id. 498 (Bankr. S.D. Ohio 1985); In re Helms, 48 B.R. 714, 717 (Bankr. 47. See In re Crown Mach. & Welding, Inc., 100 B.R. 25, 27–28 D. Conn. 1985) (balancing of interests is another important factor); (Bankr. D. Mont. 1989) (“[A]s to substantive consolidation, precedents

Published in Franchise Law Journal, Volume 27, Number 4, Spring 2008. © 2008 by the American Bar Association. Reproduced with permission. All rights reserved. This information or any portion thereof may not be copied or disseminated in any form or by any means or stored in an electronic database or retrieval system without the express written consent of the American Bar Association. 12 are of little value, thereby making each analysis on a case-by-case purchaser but to seller of contracts would, in absence of other factors, basis.”); In re Tureaud, 59 B.R. 973, 975 (N.D. Okla. 1986) (“[S]ubstan- indicate a loan secured by such contracts rather than a sale of the con- tive consolidation cases are to a great degree sui generis.”) (quoting 5 tracts); Milana, 163 P.2d at 872; see also In re Federated Dep’t Stores, Co l l i e r o n Ba n k r u p t cy ¶ 1100.06, at 1100–33 (15th ed.1984)). Inc., 1990 Bankr. LEXIS 2453, at *6–9 (1990) (approving debtor’s 48. 5 Co l l i e r o n Ba n k r u p t cy ¶ 541.07[1], at 541–30 (L. King ed., motion for authority to enter into a receivables purchase agreement, 15th ed. 2003). which provided for the debtor’s servicing of accounts, and holding 49. Chi. Bd. of Trade v. Johnson, 264 U.S. 1, 10 (1924). that neither the debtor nor its estate retained any interest in the receiv- 50. Barnhill v. Johnson, 503 U.S. 393, 398 (1992). ables sold under § 541 of the Bankruptcy Code where valid busi- 51. See Butner v. United States, 440 U.S. 48, 54–57 (1979); In re ness reasons existed for not notifying account obligors of the sale of Crysen/Montenay Energy Co., 902 F.2d 1098, 1101 (2d Cir. 1990); In the debtor’s account and the majority of collections would be made re Garten, 52 B.R. 497, 499 (Bankr. W.D. Mo. 1985). through lockbox arrangements). 52. See In re Commercial Money Ctr., 350 B.R. 465, 483–84 (9th 57. See A.B. Lewis, 421 S.W.2d at 728 (where assigned contracts Cir. B.A.P. 2006). themselves provided that payment could only be made to assigner, fact 53. See Major’s Furniture Mart, Inc. v. Castle Credit Corp., Inc., that contract obligors were not notified of the assignment and did not 602 F.2d 538, 544 (3d Cir. 1979); see also U.C.C. § 9-608 (“If the make payments directly to assignee did not prevent transaction between underlying transaction is a sale of accounts, chattel paper, payment assigner and assignee from being deemed a sale). intangibles, or promissory notes, the debtor is not entitled to any sur- 58. See, e.g., Major’s Furniture Mart, 602 F.2d at 543, and cases plus and the obligor is not liable for any deficiency.”). cited therein; In re Commercial Money Ctr., Inc., 350 B.R. 465, 481 54. Major’s Furniture Mart, 602 F.2d at 544 (footnote omitted). (9th Cir. B.A.P. 2006) (holding that the characterizations by the parties 55. See Milana v. Credit Discount Co., 27 Cal. 2d 335, 342, 163 in the documents would carry little weight where the parties attempted P.2d 869, 872 (1945) (although alleged buyer collected accounts and to characterize the transaction in different ways for different purposes customers were notified of assignment, these facts did not render the and the labels were in direct conflict with each other); In re Alda Com- transaction a sale where payment of accounts was guaranteed). mercial Corp., 327 F. Supp. 1315, 1316–17 (S.D.N.Y. 1971). 56. See A.B. Lewis Co. v. Nat’l Inv. Corp. of Houston, 421 59. See, e.g., In re Kassuba, 562 F.2d 511, 515 (7th Cir. 1977); In re S.W.2d 723, 728 (Tex. Civ. App. 1967) (the fact that customers were Bevill, Bresler & Schulman Assett Mgmt. Corp., 67 B.R. 557, 597–98 not notified of assignment and did not make payments directly to (D.N.J. 1986).

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